Synthetic Equity Arrangements
2015 Federal Budget
Christopher Steeves
5th Annual CASLA Conference on Securities Lending
June 3, 2015
Background
• A corporation that receives a dividend from a Canadian
corporation will include the amount of the dividend in income
and may, subject to certain restrictions, claim an equal
deduction so that such income is effectively received tax-free
• Avoids multiple levels of corporate tax on the same income
• For many years, the Income Tax Act (Canada) has contained
“dividend rental arrangement” rules intended to prevent a
corporation from receiving inter-company dividends tax-free in
circumstances where it did not have an economic interest in
the shares
• employs a “main reason” test
Targeted Arrangements
• According to the Department of Finance (“Finance”), certain
corporations (typically financial institutions) enter into “synthetic
equity arrangements” where the corporation acquires shares of a
Canadian corporate issuer ahead of a dividend record date and
enters into an equity derivative which provides substantially all of
the risk of loss and the opportunity for gain or profit in respect of
the share to the counterparty
• Corporation would include the amount of the dividend in
computing its income and would claim an equal deduction in
respect of the dividend compensation payment made to the
counterparty
• Additional tax benefits would be realized by the corporation
claiming the inter-company dividend deduction based on an
argument that the dividend rental arrangement rules did not apply
(receiving the dividend was not the main reason for entering the
arrangement)
Targeted Arrangements (continued)
• Finance considered this tax result to be inappropriate as the
“extra” deduction on the arrangement results in a tax loss that
could be applied to reduce other taxable income of the
corporation
• Where the counterparty is not subject to Canadian tax on the
dividend compensation payment (for example, a non-resident
of Canada or a tax-exempt entity) there is said to be potential
for the significant erosion of Canada's tax base
• While Finance indicated that synthetic equity arrangements
can be challenged by the Canada Revenue Agency under
existing anti-avoidance rules, these challenges were timeconsuming and costly
• New measures introduced to prevent these tax benefits
Proposed 2015 Federal Budget Changes
• Proposals amend existing dividend rental arrangement definition
so as to deny the inter-company dividend deduction in respect of
dividends received by a taxpayer on a Canadian share in respect
of which there is a “synthetic equity arrangement”
• Certain exceptions may apply
• Also creates an anti-avoidance provision that will apply to a
synthetic equity arrangement if:
• (i) the agreements or arrangements have the effect of eliminating
substantially all of the taxpayer’s risk of loss and opportunity for
gain or profit in respect of the share owned by the taxpayer,
• (ii) as part of a series of transactions, a “tax-indifferent investor” (or
an affiliated group of tax-indifferent investors) obtains all or
substantially all of the risk of loss and opportunity for gain or profit
in respect of the share, and
• (iii) it is reasonable to conclude that one of the purposes of the
series of transactions is to obtain the result described above in (ii)
What is a Synthetic Equity Arrangement?
• Synthetic equity arrangement (“SEA”) in respect of a share
owned by a taxpayer will be a new defined term in the Income
Tax Act (Canada) that expands on the dividend rental
arrangement rules (very generally):
• one or more agreements or arrangements that
• are entered into with a counterparty
• have the effect of providing substantially all of the risk of loss and
opportunity for gain or profit in respect of the share to a counterparty
including the benefits from a distribution on the share
• includes agreements or arrangements with a counterparty
entered into by a person or partnership that does not deal at
arm’s length with the taxpayer if it can reasonably be
considered to have entered into with the knowledge, or where
there ought to have been knowledge, that the effect described
above would result
SEA Exceptions – Trading Derivatives
• Proposed definition of an SEA excludes:
• agreements that are traded on a recognized derivatives
exchange unless it can reasonably be considered that, at the
time the agreement is executed, the taxpayer knows, or
ought to know, the identity of the counterparty
SEA Exceptions – Synthetic Short Position
• Proposed definition of an SEA also excludes:
• one or more agreements or arrangements that would
otherwise be an SEA in respect of a share owned by the
taxpayer (“synthetic short position”) if
• (A) taxpayer entered into one or more other agreements (other
than an agreement under which the share is acquired or a
securities lending arrangement) that have the effect of providing
substantially all of the risk of loss and opportunity for gain or profit
in respect of the share to taxpayer (“synthetic long position”),
• (B) synthetic short position has the effect of offsetting all amounts
included or deducted in computing the income of the taxpayer
with respect to the synthetic long position, and
• (C) synthetic short position was entered into for the purpose of
obtaining the effect referred to in (B)
SEA Exceptions – Index Derivatives
• Proposed definition of an SEA also excludes:
• agreement under which the payment or settlement
obligations are derived from, or referenced to an index
• (A) that reflects the value of 75 or more types of identical shares,
• (B) that references only long positions with respect to its
underlying components,
• (C) that is created and maintained by persons or partnerships that
deal at arm’s length with the taxpayer and the value of which is
published and publicly available, and
• (D) where the total fair market value of the shares of the capital
stock of Canadian corporations reflected in the index is not, at
any time during the term of the agreement, greater than 5% of the
total fair market value of all shares reflected in the index
Exceptions
• SEA will not result in the loss of the inter-company dividend
deduction where the taxpayer establishes that, throughout the
term of the SEA, no tax-indifferent investor (or group of affiliated
tax-indifferent investors) has substantially all of the risk of loss
and opportunity for gain or profit in respect of the share because
of the SEA
• Taxpayer is considered to have satisfied this condition if it obtains
accurate representations in writing from its counterparty that it is
not a tax-indifferent investor and it does not reasonably expect to
become a tax-indifferent investor during the term of the SEA
• Lengthy provision also detail the need for representations for
counterparties regarding the transfer or reasonable expectation
of transfer of the risk of loss and opportunity for gain or profit
• If these representations prove to be false, the dividend rental
rules will apply and the taxpayer will be denied the inter-company
dividend deduction
What is a Tax-Indifferent Investor?
• Tax-indifferent investor means
• (a) person exempt from tax,
• (b) non-resident person (unless the amounts paid under an SEA
may reasonably be attributed to the business carried on by the
person through permanent establishment in Canada),
• (c) trust resident in Canada (other than a “specified mutual fund
trust”) if any of the interests as a beneficiary is not a fixed
interest as defined in subsection 251.2(1),
• (d) partnership if more than 10% of the fair market value of all
interests in the partnership can reasonably be considered to be
held by person in (a), (b) or (c), and
• (e) trust resident in Canada (other than a specified mutual fund
trust or trust in (c)) if more than 10% of the fair market value of
all interests as beneficiaries under the trust can reasonably be
considered to be held, directly or indirectly through one or more
trusts or partnerships , by any combination of persons
described in (a), (b) or (c)
Alternative and Application
• Finance has requested feedback from stakeholders regarding
the possibility of eliminating the exception for circumstances
where no tax-indifferent investor has the risk of loss and
opportunity for gain or profit in respect of a share
• Therefore, to claim the inter-company dividend deduction, the
recipient of the dividend would have to have the risk of loss
and opportunity for gain or profit in respect of the share
• The deadline for comments is August 31, 2015
• The proposed changes related to SEAs will apply to dividends
that are paid or become payable after October 2015